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Absolute and relative purchasing power parities

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Suppose you are a currency speculator trying to forecast what will happen to the value of the dollar over the next year. Suppose all of our usual theories hold (uncovered, covered and real interest rate parities, absolute and relative purchasing power parities, as well as the Fisher effect for nominal interest rates).

  • Expected inflation over the next year is expected to be 1% in the U.S. and -1% in Europe.
  • The nominal interest rate in the U.S. for a 1-year dollar deposit is 3%, and that for a euro deposit is 2%.
  • The current spot exchange rate is 1 dollar per euro, and the forward rate for a year from now is 1.1 dollars per euro.

Reference no: EM131452787

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